Financial Options for Paying for Retirement

So perhaps you’ve been saving and investing for years, and now retirement is in your sights. The question now is, “How do I use the money in my retirement accounts and other savings to pay for things in retirement?” Today I thought I’d discuss some considerations and ideas.

How much income can I receive each month?

The first consideration is how much spending money will you have in retirement. This information might also point to the need for a part-time job or other source of income in retirement. A fairly good rule-of thumb is that you can withdraw about 3-4% of your net worth per year from your retirement account without the value declining in value in real-dollar terms. (Here “real dollar” means dollars adjusted for inflation so that you’ll have the same amount of spending power as the years go on.) If you withdraw more than this, you will be spending your portfolio over time and eventually run out of money, assuming you live long enough.

For example, let’s say you have a portfolio (401k, IRA, savings, etc…) totaling $750,000. You would be able to spend about 0.03*750,000 = $22,500 per year without seeing the value of the portfolio decline and be able to leave your heirs about the same amount of money when you died. Monthly this would be about $1875. If you were just paying for a family of two, had the house paid off, drove old cars, and didn’t do much, this might be sufficient. If you wanted a bit more of a lifestyle, you might need to work a part-time job to help with expenses. You could also consider options such as selling your home and downsizing to increase the investment portion of your net worth. If you pulled out $40,000 per year, the value would decline over time, meaning you might run into an issue in your 80’s or 90’s.

How can I generate the income I need?

The second aspect is how you use the money in your portfolio to generate the cash needed to pay for living expenses. Here there are basically three options: 1) Invest a portion of the portfolio in income producing assets to generate regular payment, 2) Sell some assets each year to raise cash, and 3) Buy an annuity to pay the income you need. Let’s look at each of those options.

1. Invest a portion of the portfolio in income-producing assets to generate income.

This is the traditional way of generating income for expenses. It works well in times when interest rates are fairly high (not the current period). Many people simply invested in bank CDs to generate income, but while the dollar value of bank CDs remains constant, value will be lost to inflation each year, plus the rate of return will always be lower than other options like bonds, real estate, and dividend-paying stocks. You can choose this option if interest rates are sufficiently high to generate the income you’ll need and you’ll have enough left over to invest in growth assets like stocks to prevent inflation from reducing your rate-of-return in the future.

Typically the percentage of income investments when you retire should be around 50%, so if you can generate enough income from bonds and dividend-paying stocks using about half of your portfolio or less, while investing the remainder in growth stocks that will increase in value with time. this could be a good option. Note that as you age, you would shift a greater percentage of your assets to income assets to increase the amount of income you receive each month to account for inflation. When you were 80, you might be 70-80% in bonds and 20% in growth stocks. You could buy individual. stocks and bonds, but it is usually easier to buy an income fund. Also note that the higher the return you’re receiving, the higher the risk you’re taking. It is generally a good idea to spread the risk out between safer, lower paying bonds and more risky, higher paying bonds.

2. Sell some assets each year to raise cash.

The first strategy is probably best if you have just enough money to generate income for retirement. If you have more than enough, you might still put a portion in bonds to help smooth out the volatility (having about 20% in bonds will greatly reduce the price level of value fluctuations in your portfolio without greatly affecting your total return), but plan on selling assets each year to raise cash for expenses. Because growth stocks will provide greater returns than bonds and income stocks over long periods of time, this will provide more money to use in retirement and/or pass on to the next generation. There will be volatility, however, so you need to have enough of a cushion to weather most market downturns that may occur. This means you really should have at least twice the portfolio value required to generate the income level you really need since a 50% decline in stocks over a short period is not common, but it does happen once-in-a-while.

Part of using this strategy involves using cash to provide the money you need during the years when the market declines and you need to wait for the market to recover before selling more shares. Since the market usually recovers within a year or less (although there are exceptions like the Great Depression), having a cash cushion will usually provide the time you need to avoid selling shares too cheaply and locking in losses. Since having a loss over a five-year period is almost unheard of, having between three and five years’ worth of cash is a conservative strategy. (Note “cash” here means bank CDs and money market funds – not $100’s in your mattress.)

If using this strategy, some level of opportunism should be used. If there are years when the markets do really well, use the opportunity to raise some cash. In years when the markets decline, maybe wait to sell unless your cash drops below some threshold, for example, 2 years’ worth of expenses.

3. Buy and Annuity to provide a monthly payment.

When you buy an annuity, an insurance company invests your money and pays you a guaranteed amount per month for the rest of your life (or some other period depending on the terms of the annuity). Because the insurance company wants to make money, they will always pay you less than the amount you could have received if you had just invested it yourself using strategies 1 or 2 above. The difference is that the rate-of-return each year would vary if you invested yourself, where it would be guaranteed (provided the insurance company didn’t default) with the annuity. The insurance company would get variable returns by investing your money, but make a higher return overall, where you would get a lower, but fixed (guaranteed) return.

Clearly, annuities have drawbacks. The income they pay is often fixed in dollar terms, so your buying power may decline over the years due to inflation. If you die young, your money may be gone so you may not have anything to leave heirs. As stated above, you will not, on average, do as well with an annuity as you will do investing yourself (assuming you invest appropriately). The exception may be if you live a really long time, but for everyone who lives exceptionally long, someone dies exceptionally early.

If you do choose to buy an annuity, avoid the fancy annuities that promise things like additional returns based on the market performance or other bells and whistles. Just buy a simple annuity that pays a fixed amount (perhaps indexed to inflation), either immediately or at a certain age (if you’re worried about running out of money late in life) . If you want to also get some market returns, hold back some cash and invest it yourself outside of the annuity.

Note finally that there is no reason to just choose one of these strategies. You can mix and match them. You could buy bonds and income stocks to generate some income, but also sell some stocks to raise cash to supplement what the bonds were paying, particularly in times like now when bonds aren’t paying much. You could also buy an annuity to pay for something critical like food and basic necessities, then use bonds and growth stock sales to pay for luxuries like travel and home improvements.

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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